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What Is a Non-Qualified Stock Option (NQSO) – Types & Issuing Options

Companies frequently choose to reward their employees with shares of their stock instead of cash or other types of benefits, such as a 401k or other qualified retirement plans. This is done for many reasons: It can provide employees with an additional avenue of compensation that is buoyed by the open market (which means that it does not come directly out of the company’s pocket), and it can also improve employee loyalty and performance.

There are several different types of plans that put company shares in the hands of its workers, but only two of them are considered to be stock “options” in the formal sense: qualified, or “incentive” stock options (also known as statutory stock options), and non-qualified, or “non-statutory” stock options. Although the former type of option is accorded more favorable tax treatment, the latter type is far more common.

Non-Qualified Stock Options

Form and Structure

As the name implies, non-qualified stock options represent an offer by the employer to the employee to buy company stock at a price somewhere below the current market price (assuming that the price either rises or at least stays the same, which, of course, it doesn’t always). The employee has the option of taking the employer up on the offer; those who do will presumably reap a profit in the long run, although this is not guaranteed.

Key Dates and Terms

Grant Date. The date on which the company grants an employee permission to buy a set number of shares at a set price within a set period of time.

Exercise Date. The date on which the employee exercises his or her right to buy the shares at the exercise price and effects a purchase transaction. The first of two dates on which a taxable event occurs for NQSOs.

Exercise Price. The price at which the employee can purchase the stock in the plan. As mentioned previously, this price is intended to be below the current market price, and companies usually set this price based upon a set discount formula from its current market price. However, it is possible for the stock price to drop below the exercise price, at which point the options become worthless, as no employee would want to buy the stock in the plan at a price above the current market price.

Sale Date. The second taxable event in the NQSO process. This is the date (or dates) on which the employee sells the stock.

Clawback Provision. Conditions under which the employer can take back the options from the employee. This can happen for various reasons, such as the death of the employee, a corporate buyout, or insolvency.

Expiration Date. The date on which the offer that was extended at the grant date to exercise the options terminates.

Bargain Element. The amount of profit that an employee gets when they exercise their options. This amount equals the difference between the exercise price and the current market price.

Offering Period. The period of time during which employees are allowed to exercise their options. There is no hard and fast limit on the length of the offering period for NQSOs, but for ISOs it must always be 10 years.

How NQSOs Are Issued

The way both types of stock options are issued is virtually identical, and fairly straightforward. The employer grants the employee the right to buy a certain number of shares within a given time period (known as the offering period) at a preset price, which is usually the closing price of the stock on the date of the grant.

If the price of the stock rises or stays the same, then the employee can exercise the options at any time during the offering period. If the price of the stock falls after the grant date, then the employee can either wait until the price goes back up or allow the options to expire.

When the employee exercises the options, he or she must initially buy the stock at the preset price (known as the exercise price), then sell it at the current market price and keep the difference (referred to as the bargain amount). The exercise process itself can take a few different forms. It is usually determined by the rules in the plan offered by the employer, as well as the employee’s personal financial circumstances:

Cash Exercise. This is the most straightforward method of exercise. The employee must come up with the cash to buy the shares at the exercise price, but will recoup this amount plus the spread (after commissions are subtracted) when he or she sells the stock.

Cashless Exercise. This is probably the most common type of option exercise, because employees don’t have to come up with any of their own money to do it. The employer usually specifies a local brokerage firm to facilitate the exercise, where employees go and open accounts. The brokerage firm then floats the employee enough money to buy the shares at the exercise price and then immediately sells them at the current market price on the same day. The firm then takes back the amount it loaned plus commissions, interest, and any other fees, in addition to withholding tax. The remaining proceeds go to the employee.

Stock Swap Exercise. Instead of cash, the employee delivers shares of company stock to the brokerage firm that he or she already owns to cover the exercise purchase.

Vesting Schedule

Both NQSO and ISO plans typically require that employees complete some sort of vesting schedule before they are allowed to exercise their options. This schedule may only depend upon employee tenure, meaning that an employee must work at the company for a certain period of time after the grant date. Or, it may depend upon certain accomplishments, such as reaching a specific sales or production-related quota. Some firms also offer accelerated vesting, which means the employee can exercise his or her options immediately upon the completion of any performance-related tasks that must be accomplished.

The time element of a vesting schedule can take one of two forms:

Cliff Vesting. The employee becomes vested in all of the options at once after a certain period of time, such as three or five years.

Graded Vesting. Usually lasts for at least five or six years; the employee becomes vested in an equal portion of his or her options each year until the schedule is complete.

Tax Treatment

Non-statutory stock options are taxed in essentially the same manner as employee stock purchase programs (ESPPs). There are no tax consequence of any kind when the options are granted or during the vesting schedule. The taxable events come at exercise and the sale of the shares.

Exercise. The amount of money that employees get from the “spread” (the difference between the price at which the stock was exercised and its closing market price on the date of exercise) must be reported as W-2 income, which means that federal, state, and local taxes must be withheld, as well as Social Security and Medicare. Federal taxes are usually withheld at a standard supplemental rate of 25%.

Sale. The sale of the stock after the options are exercised is then reportable as a short- or long-term capital gain or loss. The closing share price in the market on the day of exercise then becomes the cost basis to be used when the stock is sold. Some employees sell their shares immediately on the same day they exercise them, while others hold on to them for years.

For example, Richard’s company granted him 1,000 stock options at an exercise price of $18. Six months later, he exercises the shares on a day when the stock price closes at $30. He must report $12,000 of income on his W-2 ($30 minus $18 multiplied by 1,000 shares). His cost basis for the sale is $30. He sells the stock two years later at $45, and must report a long-term capital gain of $15,000.

Financial Planning Considerations

Stock options can impact an employee’s personal financial situation in many respects. The income realized from the exercise and sale of stock can make a substantial difference in the amount of tax owed by the employee. It is also commonly believed that exercising the stock as soon as possible, and then waiting at least a year to sell in order to qualify for capital gains treatment is always the best strategy. However, this is not necessarily the case.

If the stock price declines after exercise, then the employee can end up paying unnecessary taxes on their options. This is because they could have exercised and reported less income when the stock was trading at a lower price.

For example, John exercises his stock at $35 per share when the price is $50 and pays withholding tax on the $15 per share difference. He holds onto his shares at that time and waits for the price to rise. Instead, it drops to $40 a share over the next two years. If John had waited to exercise his shares, he would have only paid withholding tax on $5 a share. Of course, if he had sold his shares immediately after exercising them, then he would have come out the furthest ahead – but, of course there is no way to predict the stock price.

Lack of Diversification

Employees also need to seriously consider the possibility of becoming over-concentrated in their company’s stock. This can be especially relevant if an employee is also purchasing company shares through another avenue, such as inside a 401k plan or ESOP.

Those who continually exercise and purchase shares over time can easily find that a large percentage of their investment portfolios consist of their employer’s stock. Former employees of such companies as Enron, Worldcom, U.S. Airways, and United Airlines can provide a plethora of horror stories detailing the partial or total loss of their corporate holdings within a very short period of time.

Advantages of Stock Options

It is important to thoroughly understand both the benefits and limitations of NQSOs – they can benefit the employer as much (or more, in some cases) as the employees. Unless otherwise specified, all of the items listed in this section apply to both types of options:

Increased Income. Employees can substantially increase their income over time if stock price increases – and not at the employer’s expense, because the cost of the spread that employees receive when they exercise their options is borne by the open market.

Tax Deferral. Employees can defer exercise and sale until it is financially prudent for them to buy the options (before the expiration date) and sell the shares.

Improved Employee Tenure and Morale. Employers can improve employee retention, loyalty, and performance, and keep a portion of company shares in “friendly” hands.

Tax Deductions. Employers can take a tax deduction for the amount of spread employees report as income when they exercise their options.

Capital Gains Treatment. Sale of shares is eligible for long-term capital gains treatment if held for more than a year.

Disadvantages of Stock Options

Poor Diversification. Employees’ investment portfolios can become over-concentrated in company stock, thus increasing their financial risk.

No Guarantees. Options will lose all of their value if the stock price drops below the exercise price – and this possibility is determined by the open market.

Share Price Dilution. Issuance of stock options can dilute the share price of the company stock.

Cash Requirement for Exercise. Exercise of options can require employees to come up with cash up front to cover the trade if a cashless option is not available.

Tax Problems. Exercise of options can be a substantial taxable event in many cases, which can move the participant into a higher income tax bracket for the year.

Final Word

Although the mechanics of non-statutory stock options are relatively simple in nature, their exercise can have significant financial planning ramifications in many cases. The value of these options can impact the size of an employee’s taxable estate, and the timing of sales and exercises should be carefully coordinated with other financial factors in the employee’s life, such as other sources of income or upcoming deductions that can be written off against option income. For more information on stock options, consult your HR representative or financial advisor.

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Mark Cussen, CFP, CMFC has 17 years of experience in the financial industry and has worked as a stock broker, financial planner, income tax preparer, insurance agent and loan officer. He is now a full-time financial author when he is not on rotation doing financial planning for the military. He has written numerous articles for several financial websites such as Investopedia and Bankaholic, and is one of the featured authors for the Money and Personal Finance section of eHow. In his spare time, Mark enjoys surfing the net, cooking, movies and tv, church activities and playing ultimate frisbee with friends. He is also an avid KU basketball fan and model train enthusiast, and is now taking classes to learn how to trade stocks and derivatives effectively.

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